Private Equity, Corporate Governance, and the Reinvention of the Market for Corporate Control

by Karen H. Wruck, Ohio State University*

he second half of 2007 saw the end of the second wave of U.S. private equity and the beginning of a credit crunch that continues to work its way through the system. The volume of private equity transactions has dropped dramatically. In the first half of 2007, global buyout volume totaled $527.7 billion. Through mid-June of 2008, total buyouts were down to $124.7 billion, less than a quarter of the prior years volume. Buyouts over $1 billion in the first half of 2007 numbered 93; in the first half of 2008 there were 32. And the buyouts that are getting done are using notably less leverage, with debt averaging 4.9 times EBITDA in the first half of 2008 as compared to 6.3 times in the first half of 2007. Another telling indicator of the change in the private equity market is the rate at which agreed-upon buyouts are now being terminatedthat is, renegotiated or abandoned. Over 20% of the deals struck in 2007 are either rejected or reworked. (By comparison, the percentage of buyouts thus terminated in previous years was 8.3% in 2006, 12.0% in 2005, and 13.1% in 2004.1) Some terminated transactions, such as the $6.5 billion Hexion/Huntsman/Apollo deal, are being litigated.2 Others have avoided litigation, such as the $6.1 billion Penn National Deal in which the banks have agreed to contribute $550 million in cash toward a $1.25 billion out-of-court settlement.3 And still other deals have been salvaged at lower prices and/or with less generous borrowing terms, including Clear Channel, Home Depots Supply Division, and the $52 billion buyout of Bell Canada.4 All this amounts to a sea change in the industry outlook. As late as mid-2007, Henry Kravis of KKR and others were celebrating what they identified as the golden age of private
* This article is based on a presentation given at the American Enterprise Institute, Conference on The History, Impact and Future of Private Equity: Ownership, Governance and Firm Performance, November 27, 2007, Washington D.C. I would like to thank John Chapman, Michael Jensen, Steve Kaplan, Josh Lerner and Annette Poulson, and especially Don Chew for helpful discussion, questions, comments, and suggestions. Research support from the Dice Center for Financial Research, the Fisher College of Business, and The Ohio State University is gratefully acknowledged. 1. Source: Deal Journal, The Wall Street Journal, July 3, 2008, July 7, 2008, which relies on data from Dealogic, Private Equity Analyst, Standard & Poors, Moodys Investor Services, and FactSet MergeMetrics. 2. See for example, Peter Lattman, Hunstman Sues Apollo in Texas Over Buyout Battle, The Wall Street Journal, June 24, 2008. 3. Peter Lattman and Tamara Audi, Wachovia, Deutsche Bank Bring End to Penn National Deal, The Wall Street Journal, July 4, 2008. 4. Heidi Moore, Private Equity Wins Again: BCE Buyout Proves the Customer is Always Right, The Wall Street Journal, July 7, 2008. 5. Allan Sloan and Katie Benner, The Year of Vulture, CNNMoney.com,

equity. But just six months later, at the World Economic Forum, David Rubenstein of the Carlyle Group stated that the golden age of private equity was over, and that the industry had entered a purgatory age in which it would be made to atone for its sins.5 As we now know from almost three decades of experience, private equity markets are prone to boom-bust cycles. Several factors have been identified as contributing to these cycles, including relaxed credit market conditions, aggressive deal pricing (reflecting intense competition for deals), and the incentives of many dealmakers to do overpriced deals.6 Viewed in this light, the sudden fall of private equity does not come as a complete surprise. Even before the end of the second wave in 2007, the performance of private equity firms was being subjected to increased scrutiny and skepticism. In fact, while the funds put together by the top private equity firms have produced persistently strong returns over the years, one widely cited study reported that the average returns (net of fees) produced by a large sample of private equity funds established between 1983 and 1997 failed even to match the return to the S&P 500.7 At the same time their average returns were being called into question, private equity firms also began to come under attack for taking advantage of the provision of the U.S. tax code that allows partnership earnings from carried interest to be taxed at capital gains rates rather than as ordinary income.8 This tax controversy was fueled by detailed and much-publicized reports of the personal wealth being amassed by principals in private equity firms.9 Without understating the importance of the issues raised above, Id like to set them aside until the end of this paper.
May 15, 2008. 6. The incentives of dealmakers are a function of the payoffs they receive from fees, carried interest, and so forth. As discussed at the end of this article, high levels of fees in relation to equity commitments are a prescription for overpriced (and thus too many) deals. For a discussion of the factors leading to boom-bust cycles in LBOs, see Jensen (1991), Kaplan and Stein (1993), Kaplan and Schoar (2005), Axelson, Jenkinson, Strmberg and Weisbach (2007). Full citations of all academic papers cited in this article can be found in the References at the end. 7. Kaplan and Schoar (2005) run an experiment for each buyout fund in their sample. They assess the value returned to investors by the buyout fund and compare it to the value that would have been returned to investors had they instead made the same investment in the S&P 500. They find that the S&P investment strategy would have been worth 25% more on average. Moreover, to the extent the beta of private equity is greater than one, the return to the S&P 500 understates the correct performance benchmark. 8. See Fleischer (2008). 9. Henry Sender, How Blackstone will Divvy up its Riches, The Wall Street Journal, June 12, 2007.

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My primary goal in these pages is not to explore the causes of boom-bust cycles or other major controversies that now surround private equity. Nor do I claim any special ability to predict specific industry trends. Rather, my purpose is to show how the private equity market, for all its problems and cycles, has helped reinvent what economists refer to as the market for corporate controlparticularly in the U.S., which is home to the worlds largest such market. And by reinvigorating the U.S. corporate control market, private equity has had profoundly positive effects on the governance and performance of U.S. public companies. Indeed, these effects are important enough to warrant a new definition of the market for corporate controlone that, as presented below, emphasizes corporate governance and the benefits of the competition for deals between private equity firms and public acquirers or, in industry parlance, between financial and strategic buyers. Along with improvements in governance, the early buyout firms also pioneered a distinctive approach to reorganizing companies. Scholars and practitioners alike have recognized the combination of high leverage, strong governance, and increased management equity ownership as a key contributor to the success of LBOs.10 Less appreciated, however, is the ability of early buyout firms such as Berkshire Partners, Clayton & Dubilier, Forstman Little, Hicks Muse, and KKR to develop what might be described as a new approach to reorganizing businesses for efficiency and value. My own research on private equitywhich includes multiple case studies, interviews with buyout specialists and managers of firms acquired in buyouts, and large-sample research on private equity markets and highly leveraged transactionshas led me to identify four principles of reorganization that help explain the success of the top buyout firms. When applied effectively, these principles required changes not only in corporate governance, but in day-to-day management decision-making and operating practices, in the measures used internally to evaluate performance, and in the incentive-and-reward structures used to motivate managers at all levels of the firm. (Leverage, on the other hand, plays a secondary role; the main role of debt in private equity transactions, as I argue below, is to make possible the concentration of ownership that is critical to effective governance and strong incentives.) In addition to providing a source of competitive advantage for the top buyout firms, the management practices that derive from these four principles of reorganization have been adopted by many public companies in their pursuit of shareholder value. In this sense, the impact of private equity
10. See for example, Kaplan (1997) and Kaplan and Holmstrom (2001), (2003). 11. The evidence showed that most of the value gains accrue to target shareholders, with bidder shareholders experiencing no gain or a small decline. The decline was attributed to a tendency by bidders to overpay in friendly deals. For example, in a study of 47 hostile takeovers (larger than $100 million) attempted in 1985 and 1986, Bhide

extends well beyond the thousands of companies worldwide that have had direct dealings with private equity firms. As I suggest in this paper, private equitys most important and lasting consequence for the global economy may well be its effects on the worlds public corporationsthose companies that will continue to carry out the lions share of the worlds growth opportunities. Development of the U.S. Market for Corporate Control With the rise of unsolicited (or hostile) takeovers in the late 1970s and early 1980s, finance scholars, corporate managers, and the press turned their attention to the effects on the economy of mergers, acquisitions, and other corporate control transactions. At this time, hostile deals were typically decried by the press and corporate executives as driven by greed and damaging to U.S. competitiveness, employees, and local communities. And the creation of a high-yield debt market for new issues and the emergence of private equity in the early 80s meant that, for the first time, even very large firms were vulnerable to attacks by corporate raiders like Boone Pickens and Irwin Jacobs. But financial economists took a very different view of these new developments. A small but growing body of papers was reporting consistent evidence of shareholder gains in M&A transactions, particularly in hostile deals.11 And in a much-cited 1983 article that surveyed this new literature, finance professors Michael Jensen and Richard Ruback cut through the controversy and rhetoric by introducing the concept of a market for corporate control. After defining it as the market in which alternative management teams compete for the right to manage corporate resources, Jensen and Ruback went on to call it an important component of the managerial labor market. In other words, by acquiring another firm (generally at a significant premium over its current market price), and then making improvements in its performance sufficient to justify the purchase premium, an acquirers managers were demonstrating their superiority to the managers of not only the acquired firm, but of all actual or potential competitors for the same assets. Viewing the market for corporate control as an extension of the managerial labor market was a new and powerful idea. If the management team of a large public company was clearly failing to make the most of the investor capital and other corporate resources at its disposal, the corporate control market provided a means by which a more efficient and effective teamwhether from another public company or backed by unaffiliated investorscould buy the right to manage those resources, thereby creating value for sharehold(1989) reported that the targets of hostile deals tended to be low-growth, poorly performing, diversified companies with little management ownership. By contrast, the targets of the 30 larger friendly deals transacted in the same period tended to be singleindustry firms with strong performance and high insider ownership.

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ers and the economy in general. The price for that right was the amount necessary to gain control of the underperforming firm. A primary contribution of the scholarly research and the new definition of the market for corporate control was thus to change the tone of the debate, shifting the focus away from the greed of financiers and the unfortunate effects of some deals on employees and local communities, and toward the importance of improving the efficiency of resource allocation and use in public corporations. As a consequence, while ethical questions of greed and fairness will always be with us, efficiency and value are now widely accepted as the most important social criterion in transactions involving changes in corporate control. Viewed in the context of a well-functioning market for corporate control, underperforming public companies represent profit opportunitiesopportunities that in turn provide strong incentives to mobilize capital, acquire underused assets, and find ways to capture value by reversing underperformance. Such profit opportunities, and the resulting incentives, gave rise to the first major wave of U.S. private equity transactions in the early 1980s. And this first wave of leveraged buyouts, when viewed together with hostile takeovers (also typically leveraged), can be seen as the beginning of the development of an effective U.S. market for corporate control. But it was only the beginning. At that time, the ability of potential acquirersparticularly unaffiliated raiders and private equity firmsto profit from corporate underperformance was limited by the relatively small size of the high-yield and private debt markets, and by the size of the private equity market. Another critical constraint was the limited number of private equity shops then capable of reorganizing underperforming firms. As a result, the U.S. market for corporate control market was underdevelopedand its lack of development was a major contributor to a governance system notably lacking in either internal or external constraints on management.12 Inside U.S. public companies, corporate managers with minimal stock ownership or other equity incentives were focused mainly on growth and diversification, often at the expense of profitability and value. Take the case of General Mills in the late 1970s. The companys stated mission was to become the all-weather growth company, which it aimed to carry out by using the flood of cash flow from its core cereal businesses to diversify into toys and games, specialty retail, travel services, and rare coins and stamps. The eventual outcome of this diversification was a serious decline in profit12. As Jensen summarized the situation, the managements of U.S. public companies in the early 80s could preside over the destruction of up to a third of the value of their organizations before facing a serious threat of displacement by either their boards or outside investors. Michael Jensen, Corporate Control and the Politics of Finance, Journal of Applied Corporate Finance, Vol. 4 No. 2 (Summer 1991), p. 22. 13. Donaldson (1990), pp.139. 14. In 1990, the remaining operations were sold to ConAgra. And, according to calculations made by George Baker, Beatrices shareholders recovered most if not all of the value lost through its poor diversification strategy in the $1 billion purchase premium

ability and stock priceand it required a series of voluntary divestitures and spinoffs spanning more than a decade to undo the damage. After studying this situation, Gordon Donaldson of the Harvard Business School concluded that it was a minor miracle that it [the voluntary restructuring] happened at all [and it] cost ten years of opportunity to reap the benefits.13 In the case of another conglomerate, Beatrice Foods, it took an LBO (completed in the face of a hostile takeover offer) to bring about the needed restructuring. But unlike the case of General Mills, the changes at Beatrice were made quickly. The companys $8.1 billion LBO, which was sponsored by KKR, closed in late 1985. By the end of 1987, just two years later, the company had spun off or divested $6.55 billion in assets, retaining only the domestic food operations. The net effect was significant value added for KKR and its investors, as well as a recovery of lost value by Beatrice shareholders in the form of the large purchase premium paid by KKR to gain control of the firm.14 The diversification strategies of General Mills and Beatrice Foods, while reflecting managements preference for growth over value, were at least tacitly supported by their boards of directors. Although nominally representatives of the shareholder interest, corporate directors were generally handpicked and dominated by the CEO (who also often chaired the board). And the underdeveloped state of the corporate control market at that time meant that dissatisfied shareholders had little recourse outside the firm. With hostile takeovers still politically and socially unacceptable, and limited funding for the few investors willing to bear the stigma of being a corporate raider, the external sources of control needed to curb corporate managers pursuit of growth at all costs were as yet in a formative stage. As a result, tales of diversification followed by major restructuring were repeated countless times in the 70s and 80s.15 But, as the history of the U.S. market for corporate control also makes clear, if the abysmal performance of U.S. companies in the late 70s was the reflection of failed governance, it also became the catalyst for major governance reform. A Closer Look at the Corporate Governance Problem Most business journalists, and many finance scholars, tend to write about capital markets and corporate governance as if they were two distinct subjects. But the connection between capital markets and governance is fundamental: how a company chooses to raise its capital effectively determines
paid by KKR; and when this premium is added to the $1.2 billion ultimately realized by KKR and its investors, the net gains to all shareholders (buying as well as selling) from Beatrices LBO were estimated at $2.2 billion. See Baker (1992). Today, perhaps the most notable remnant of Beatrice is the successor to Borden Chemicals, Hexion, a private specialty chemical firm controlled by Leon Blacks Apollo. 15. In his study of 28 successful hostile takeovers completed in 1985 and 1986 (cited earlier in note 11), Bhide (1989) notes that, after the 28 deals closed, 81 businesses were soon divested; and of the 81, as many as 78 had been previously acquired rather than developed from within.

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the kind of governance system it will be subjected to. The objective of a governance system is to ensure that the interests of a companys managers are consistent with those of its shareholders. This raises the basic question of why, in most large enterprises, the top managers are not the dominant shareholders. The answer has to do with comparative advantage in risk-bearing. From economists vantage point, the principal advantage of the public corporation is its efficiency in spreading risk among well-diversified investors, thereby providing the firm with a low-cost source of equity capital. In fact, the public corporation can be thought of as an ingenious risk management devicea form of organization that allows equity investors to specialize in bearing the residual risk of the firm without having to manage it, while at the same time allowing managers to run the firm without supplying the capital and bearing the entire residual risk of the business. Consider the case of General Electric. At the end of 2007, the firms market cap stood at $374 billion16an amount that had fluctuated by an average of $3.7 billion per day during that year. It is hard to imagine an individual, or small group of individuals, having both the expertise to run GE and the capital and risk tolerance to bear the residual risk of such a huge enterprise. But this separation of management and risk-bearing has a downside: the need for corporate governance and incentive compensation to help ensure that the managers serve the interests of the residual risk-bearing shareholders. In their pathbreaking 1976 paper on agency costs, Jensen and his colleague Bill Meckling identified and analyzed potential conflicts of interest between management and shareholders as a principal-agent problem. As we saw earlier in the cases of General Mills and Beatrice Foods, managers place a higher value on growth, size, and diversification than shareholders (who, of course, can diversify their own portfolios). And as this managerial preference for size and diversification suggests, investors also have greater tolerance for risk-taking, provided the anticipated returns are high enough to justify the risks. When the expected returns fall below the cost of capital, investors would prefer that the firms excess capital be paid out in the form of dividends and stock repurchaseswhile risk-averse managers, all else equal, would prefer to keep the cash inside the firm. Corporate managers, then, when viewed as self-interested and risk-averse agents for their shareholders, tend to prefer more than the value-maximizing amount of growth and assets, and less than the optimal amount of risk-taking
16. According to the CIA Worldfact book, this is slightly greater than the 2007 official exchange rate GPD of Sweden ($371.5 billion) and slightly less than the official exchange rate GDP of Switzerland ($386.8 billion)). 17. A defective governance structure is analogous to the non-surviving organizational form identified by Fama and Jensen (1983 (a) and (b)). Adopting their terminology more precisely, a firm in which decision management rights are co-located with decision control rights and at the same time separated from residual risk bearing cannot survive. Moreover, Jensen and his colleague Bill Meckling were sufficiently pessimistic about the U.S. governance system in the early 1980s that they published an article called Can the

and payouts to investors. Agency costs consist partly of the direct costs incurred in trying to manage these conflicts say, in the form of auditing fees, and the costs associated with executive contracts and incentive comp plans. And, given the impossibility of eliminating these conflicts through contracts alone, agency costs also include the residual loss in firm value that results from having limited governance and board oversight over managers without significant equity stakes. For our purposes, whats important to keep in mind is that such agency costs are recognized, and reflected in the stock prices of public companies, by outside investors who understand the limits of their information and control. The role of governance, then, is to give the shareholders some degree of control over managers whose interests are not fully consistent with their own. To put this in more formal terms, in companies where managerial decision-making and residual risk-bearing have been separated, the residual risk bearers must possess and be able to exercise what I will later call governance rights. Moreover, they must be able to exercise such rights not only after things have clearly gone wrong, but at critical points when companies are contemplating new strategies or major organizational changes. When residual risk bearers have no governance rightsa condition that many finance scholars view as an accurate characterization of corporate America up through the early 1980sagency problems lead predictably to widespread underperformance and value destruction.17 Effective Corporate Governance: The Private Equity Model The governance structure used by top private equity firms has been the subject of considerable study by finance academics, and its main features are now well documented.18 The typical board of a private-equity controlled company has relatively few (generally five to eight) members, a non-management chair, and only one management director. Among the nonmanagement directors are financiers and individuals with strong management experience or industry expertise. Finally, and perhaps most important, the board of directors has significant equity-based incentives, either through direct share ownership or an incentive structure whose payoffs are tightly linked to appreciation in share value (including carried interest). A good example is the post-buyout governance structure of O.M. Scott, a lawn and plant care company that in 1986 was bought from its conglomerate parent ITT by the buyout
Public Corporation Survive? There they argued that U.S. policymakers and managers of U.S. companies had so lost sight of their primary obligation to efficiency and shareholder value that their future as competitive enterprises was in doubt. In other words, managers of public companies were failing to serve stockholders; and given the state of the stock and IPO markets, which reflected such poor performance, competent owners of private companies intent on maximizing value would simply choose to remain private. 18. See, for example, Jensen (1989) and Baker and Wruck (1990).

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firm Clayton & Dubilier (C&D). Upon taking control of the company, C&D established a five-person board of directors, with one management director, three C&D partners, and one outside director with extensive operating experience. One C&D director served as Scotts operating partner, working with managers to develop an effective strategy for improving performance. The C&D partners represented a 61.4% equity positiona position that, when combined with managements and employees equity stake of 17.5%, is representative of the highly concentrated ownership structure associated with buyouts.19 A comparison of Scotts governance under C&D to its pre-buyout governance as part of ITT illustrates how private equity addresses the agency problems endemic to large, and especially diversified, public corporations. Prior to the buyout, Scotts top executive was one of many division managers in ITTs consumer products group. He reported a few times a year to ITT headquarters and what equity he had consisted of stock options in ITT. ITT was itself governed by an 11-member board whose equity ownership totaled 0.6% of the shares outstanding. After the buyout, Scotts top manager was the CEO and 10% equityholder of a standalone company, reporting on a weekly (if not daily) basis to a five-person board that included three partners of C&D, the 60% owner of his companys stock. As the features of the Scott deal are meant to suggest, private equity firms combine significant and concentrated share ownership with effective board oversight, thereby reuniting the corporate risk-bearing and governance functions that are separated when companies go public. And the results of such changes in ownership and governance have been impressive. Within two years of being acquired by C&D, for example, Scott had increased its sales by 25% and its earnings before interest and taxes (EBIT) by over 50%. And these earnings increases, which were achieved while raising spending on R&D and marketing and distribution, are consistent with those reported for large samples of private equity buyouts. For example, two separate studies of large samples of LBOs in the 1980s both reported 40% average increases in operating income during a two-year period following the buyouts.20 Another study of LBO companies that eventually went public through IPOs (known as reverse LBOs) showed that these firms not only became more profitable after going private, but continued to be more
19. Over the next few years, three new directors were added. One was an academic turf-expert, one was a consumer products expert, and one was the president of a company Scott acquired after its buyout. Each of these directors received significant compensation in the form of stock options. 20. Kaplan (1989), Smith (1990). 21. Cao (2008), Cao and Lerner (2007). 22. To see the tradeoff more clearly, recall that the main advantage of diffuse ownership is the relatively low cost of equity that results from providing investors with liquidity and the opportunity to diversify away firm-specific risk. In a private equity structure, managers are exposed to firm-specific risk through their human capital and share ownership, but have strong incentives to maximize value. General partners are less exposed to firm-specific risk since they invest in a number of portfolio companies and may have

profitable than their industry peers during the first two years after their IPOs.21 Costs of Going Private But, as the decision by some LBO companies to return to public ownership suggests, there is also a major cost to concentrating ownership: at bottom, the decision to go private means forgoing the risk-bearing economies and the resulting lower cost of equity capital provided by equity public markets. In other words, the benefits of better corporate governance and stronger incentives that are made possible by concentrating equity ownership come at the cost of restricting shareholders access to liquidity and their ability to diversify risk. In this sense, going private represents a decision to trade off efficiencies in risk-bearing and lower-cost equity for the gains associated with concentrated equity ownership and the stronger governance and incentives that come with it.22 And it is these costs of going private that ensure that the governance structures implemented by private equity firms in most of their individual portfolio companies are not permanent. At some point, private equity deals seek a major liquidity event that allows investors to sell all or part of their investment. Indeed, the finite life of the limited partnership structure underlying private equity, typically seven to ten years, eventually forces the occurrence of such an event.23 One possible liquidity event is that the portfolio company is sold to another private equity group (or, alternatively, pays a liquidating dividend to its current owners and is recapitalized, with some changes in ownership). In such cases, although the cast of characters may change, the company stays private and the basic governance and equity ownership structure likely remains the same. Another common outcome is sale of the firm to another corporation, public or private, in which case the firm becomes subject to the governance system of the buyer. A third possibilitylimited mainly to larger buyouts by the most reputable buyout private equity firmsis public ownership through an IPO. In the case of such reverse LBOs, the firms managers and investors sell part of their equity stake, thereby diluting ownership concentration; and the infusion of new equity has the effect of reducing leverage. And after the IPOs, the debt of reverse LBO firms continues to fall, and the structure of their boards and their management incentive plans begin to look more like those of typical public companies. But somewhat surprisingly, in light of these post-IPO
well-diversified personal portfolios. Nevertheless they bear more firm-specific risk than well-diversified, passive equity investors because of the illiquidity of their investments and the potentially large effects of deal outcomes on their reputations and human capital. Limited partners, by contrast, have the greatest opportunity to hold well-diversified portfolios. They are generally, although not always, large institutional investors with only a portion of their assets allocated to alternative investments such as private equity. 23. According a study by Steve Kaplan of 183 LBOs larger than $100 million that were closed during the period 1979-1986, 62% of the LBO firms remained privately owned four or more years after their buyout, another 24% were owned by public companies, and 14% were independent publicly traded firms. Of the LBO firms that remained private, some continued to be owned by the original buyout firm, but others had been purchased by other private firms.

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changes in ownership and capital structure, a recent study by Jerry Cao and Josh Lerner of more than 500 reverse LBOs that went private during the period 1983-2001 reports that such companies outperformed both the broad stock market and other IPOs for several years after their return to public ownership.24 This performance suggests that, having experienced the benefits of private equity-style governance and management, public companies do not completely revert to their pre-buyout ways. In other words, we may have evidence of permanent organizational change and learning (a point I will come back to). A New Approach to Reorganizing for Value In addition to a superior governance model, private equity can be credited with a second major contribution: the development of a systematic approach to reorganizing companies for efficiency and value. Perennially successful buyout firms have used this approach to increase the productivity of many portfolio companies, in most cases without changing top management or the firms core assets. In the process, they have developed specific knowledge and skills that allow them to tackle the challenges posed by the next portfolio firm quickly and effectively. In other words, the reorganization process becomes sufficiently routine to the point where it can be thought of as a reorganizing technology, a source of competitive advantage and value in itself. In any reorganization effort, there are two primary questions that must be addressed. One is which assets should remain with the organizationand which should be sold or shut down? The second is what is the best organizational structure for a given enterprise? Private equity firms decide which assets should remain based on their contribution to firm value; assets that cannot earn their required rate of return on capital under private equitys ownership are sold or shut down. In discussing the approach of private equity to reorganization, I find it useful to begin with a corporate coordination and control framework that was developed by Jensen and Meckling to address the dual problem of managing information and incentives in large organizations.25 The framework identifies three critical elements of organizational structure: 1. The allocation of decision rightsthat is, who gets to make what decisions? 2. Internal performance measurementhow is success defined for the firm, for business units, and for individuals? 3. Reward and punishment systems, including promotion
24. Cao and Lerner also found that the buyout sponsors owned an average of about 55% of the equity in their portfolio firms just before the IPOs. After the IPOs, their average ownership stake dropped to about 38%. Leslie and Oyer (2008) find that differences in debt and in management compensation between LBO and public companies tend to narrow (and then disappear) during the two years following the IPO. 25. See Jensen and Meckling (1995). 26. See, for example, Baker and Wruck (1990), and Wruck (1991, 1994, 1997a and 1997b) .

and compensation systems. Note that although compensation gets a lot of attention, it is only part of the story. And because of the difficulty of getting informationparticularly in private firmsabout internal decision-making structures and performance measurement systems, these first two elements of organizational design are often overlooked. But, as documented by a body of case studies and other field research, buyouts by private equity firms tend to be followed by dramatic changes in both decision-making authority and performance measures.26 To offer one example, while visiting Sterling Chemicals over a several-year period after its 1986 buyout by Gordon Cain, I found clear evidence of the potential value from decentralizing decision-making. In the case of Sterling, decentralization was the outcome of a firm-wide quality management program that aimed to exploit the specific knowledge of managers and employees throughout the firm by expanding their decision rights. And this empowering of employees was accompanied by major changes in the firms performance measurement and reward systems. Especially notable among such changes was the adoption of profitsharing and employee stock ownership plans for Sterlings highly unionized workforce. This combination of changes provided employees with both the decision-making autonomy and the incentives to put their accumulated specific knowledge to work in ways that improved performance. And, as I reported in my study, the result was a significant increase in value.27 Another reorganization I observed at close quarters was Safeway. In 1985, Safeway was the largest public grocery store chain in the U.S. Faced with a number of challenges, including an inability to compete with strong regional chains that used non-union labor, the company became the target of a hostile takeover offer. In response, management took the company private in a $4.3 billion LBO sponsored by KKR. As part of its reorganization under KKR, Safeway made a simple but important change in its performance measurement systems. Before the buyout, Safeways key performance measures were based on sales and net income benchmarked against those of other national grocery chainswhich, it turns out, were not its fiercest competitors. After the LBO, Safeway developed a performance measure called return on market value, or ROMV. ROMV was the ratio of annual operating cash flow to the estimated market value of assets
27. Between 1987 and 1988, Sterlings sales increased from $413.2 million to $699.0 million, and EBITDA increased from $129.0 million to $340.1 million. The outstanding performance in 1988 was in part due to increases in operational efficiency and in part due to a substantial increase in the the world price of styrene monomer, which increased Sterlings margins because styrene was a major product. By the end of 1988, the company had reduced its debt to $90.8 million from $200.5 million at the time of the buyout, and paid $190.3 million in dividends. The dividend payout was almost 28 times the $6.8 million equity investment made at the time of the buyout. For more detail see Wruck and Jensen (1994).

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(and hence the amount that could be realized by selling those assets). The market value of assets was determined primarily through the appraisal of Safeways real estate holdings, which were then marked to market. ROMV was calculated at both the divisional and corporate level, and management bonuses were tied to achieving a 20% target ROMV. With the help of ROMV, Safeways managers identified stores and divisions with substandard performance. If they could not be made competitive, they were marked for sale or closure. And the fact that, after the buyout, Safeways managers owned 10% of the companys common stock ensured that they had strong incentives to make such difficult decisions. (Before the LBO, Safeways managers and directors as a group owned just 0.6% of its common stock.) Following these changes in performance measurement and compensation, the company sold $1.8 billion in assets. In the process, they were able to renegotiate about half of their 1,300 labor union contracts. Managements focus then turned to improving the performance of the stores that remained. And improve it did: After running for five years under its revamped performance measurement and compensation systems, the company had increased its enterprise value by $1.6 billionan increase that came after, and on top of, KKRs payment of a $1.8 billion takeover premium to buy the company from Safeways public shareholders. Four Principles and a Question of Competitive Advantage. To sum up, then, my synthesis of a large and growing body of research points to a set of four principles that can be viewed as the foundation of the reorganizing approach taken by the best private equity firms: 1. Governance by a small board of directors with significant equity ownership; 2. Decentralization of decision-making; 3. Adoption of new performance measures that emphasize cash flow and long-run value; and 4. Adoption of a new management compensation system that includes: a. Higher levels of compensation, with more pay at risk, b. Bonuses based on cash flow and/or value metrics, and c. Significant percentage management equity ownership. The bottom line here is that a major part of the long-run success of private equity can be attributed to its ability to reorganize companies in a way that makes the most of their existing knowledge, managerial expertise, and assets. This is crucial when it comes to day-to-day decision-making, detailed problem-solving, and issues of implementation. In other words, I would argue that, although the best buyout firms
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have the ability to govern their operating companies, they do not generally have the ability to manage them. And while its true that many buyout firms have added operating capability in the form of experienced corporate managers (many of them former CEOs) to their own staffs, this capability is not a substitute for effective management and reorganization at the portfolio firm level. This makes reorganization based on effective decentralization and performance measurementand-reward systems a critical part of the private equity success story. A schematic of the process is presented in Figure 1. An important question, then, is the extent to which these four reorganizing principles constitute a source of sustainable competitive advantage. The answer is not obvious; after all, the principles identified above are not rocket science. But they may be hard to put into practice. As one example, there is no shortage of public information documenting Southwest Airlines business strategy, organization structure, and management practices, yet no other airline seems to be willing and able to replicate its success. The Secondary Role of Debt. Also worth noting here is that substantial debt or high leverage is not one of the four principles. This is not because debt is unimportant in buyout transactions, but rather because, in an organizational and management sense, its role is a secondary one. Set aside for a moment the tax benefits of debt, and the higher returns associated with leveraged equity. From an organizational perspective, the primary role of debt financing is to make possible the creation of the concentrated equity ownership structure that is fundamental to the effective governance and strong incentives associated with buyouts. Leverage accomplishes this concentration of ownership by shrinking the dollar amount of equity required to buy the portfolio firm to the point where managers can own a significant percentage equity interest and private equity investors can own the rest. In tight credit market conditions like todays, private equity transactions will be done with less leverage, and hence produce fewer tax benefits and less leveraged (and thus lower) equity returns. Even so, todays credit market conditions should not prevent private equity firms from effectively reorganizing those portfolio firms they do manage to acquire. Indeed, tight credit markets and a soft economy are likely to make reorganizing capabilities even more important since there are fewer alternative sources of value to exploit. Finally, to the extent that easy credit encouraged the entry of private equity firms that were less skilled at governance and reorganization, current conditions will expose their limitations, identify them as marginal players, and force them to shrink or exit. Private Equity Markets and the Contest for Governance Rights The last 20 years have seen the evolution of a more competitive and dynamic market for corporate control, not only in the U.S., but in the U.K. and increasingly in continental
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Reorganizing the Firm for Value

Weak Corporate Governance

Focus on size and growth rather than value, weak internal capital markets

Underperformance

Pressure from the Market for Corporate Control

Hostile Takeover Offer, LBO as an Alternative

Asset Sales, if necessary Private Equity-Style Governance

high leverage facilitates concentrated equity ownership Changes in Organizational Rules of the Game 1) Decision rights decentralized 2) New Performance Measures focus on cash-flow rather than EPS and on firm value rather than size or growth 3) Rewards that align incentives with bonuses based on new performance measures and management-equity ownership

Improved Strategy and Decision-making

Utilizing valuable specific knowledge through effective decentralization allocating capital more efficiently

Improved Performance and Value Creation

Europe and Asia. And one predictable effect of this development has been to strengthen the governance systems and improve the performance of public companies, even those that have not been parties to private equity or any kind of control transactions.28 To illustrate these indirect benefits of a well-functioning corporate control market, one common response by public companies to the potential threat posed by hostile takeovers and LBOs in the 1980s (as we saw in the case of General Mills) was to sell non-core businesses worth more in the hands of other companies or investors. Another response, often combined with such asset sales, was to borrow (or use the proceeds from the sales) to buy back shares in what became known as leveraged recaps.29 As these examples are meant to suggest, many companies recognized that the best way to protect themselves from the threat of takeover was to anticipate the acquirers action and do it themselves. But a more fundamental solution, as many companies also learned, was to adopt at least some aspects of the more effective governance and management processes of their would-be acquirersthose processes that were leading companies to volunteer to sell underused assets and to distribute excess capital.30 Much of this restructuring activity came to a halt in the early 90s when the market for leveraged (and hence most hostile) transactions was essentially shut down, in large part through regulatory overreaction.31 At that point, large institutional investors responded to the resulting governance vacuum by using their new clout to become more active in confronting the boards of underperforming companies, taking advantage of relaxed restrictions on proxy fights, and encouraging companies to provide top executives with more generous equity incentives, mainly in the form of stock options.32 But when leveraged financing markets began to recover in the mid-90s, the U.S. private equity markets made a dramatic comeback. The volume of U.S. private equity deals soared from $35 billion in 1996 to $782 billion in 2007. And private equity played a growing role in M&A transactions, participating in over 20% of total deals in 2007s $4.4 trillion
after increasing its quarterly dividend by 50% in April 2006, sold its printer division into a joint venture arrangement in January 2007, and announced a $15 billion share repurchase plan in April 2007. Its also interesting to note that, at around the same time, a number of technology firms became private equity targets and IBMs former chairman Lou Gerstner became Chairman of the private equity firm The Carlyle Group, prompting rumors of IBM as a possible target. 31. See Jensen (1991), Corporate Control and the Politics of Finance. 32. Holmstrom and Kaplan (2001, 2003) identify a number of important causal factors that helped bring about improved governance. Among them are the dramatic increase in the fraction of shares held by institutional investors and 1992 changes to SEC rules reducing the cost of mounting a proxy fight; these combined to increase shareholder activism. Consistent with increased activism is evidence of an increase equity-based compensation for executives and directors, some evidence of a reduction in the size of boards, and an increase of the sensitivity of CEO turnover to performance (Kaplan and Minton (2008)). While there have been improvements, longstanding governance critics like Michael Jensen and Robert Monks argue that there are still major problems in need of reform. (JACF Roundtable Discussion on Corporate Governance (Winter 2008)).

28. In addition to the private market-based solutions discussed below, some of the more recent improvements have been attributed to the regulatory response to highly publicized governance failures such as Enron and WorldCom. The Sarbanes-Oxley (SOX) Act, passed in 2002, and the adoption of governance rules and guidelines by stock exchanges, made certain governance practices mandatory. SOX places restrictions on insider trading and emphasizes the independence of the audit committee, focusing on internal controls and transparency in reporting. NYSE rules and guidelines, adopted in late 2003, require that the majority of directors be independent, that the compensation and nominating committees be comprised of independent directors, that non-management directors meet regularly without managers present, that shareholders vote on the adoption of new equity compensation plans and on material revisions to existing plans, and that companies make their corporate governance guidelines available. 29. See Wruck (1991) for a discussion of the governance, organizational and value changes associated with Sealed Air Corporations leveraged recapitalization. See also Palepu and Wruck (1992), who show that companies undertaking recapitalizations as a defensive measure underperform other recap firms following the transactions. 30. A recent example of a very large public company taking such steps is IBM, which,

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M&A market (as compared to just 3.1% in 1996).33 Private equity also became a global phenomenon, with substantial growth in the U.K., continental Europe, and other parts of the world. Between 2001 and 2007, 12% of all global LBO transactions were done outside North America and Western Europe.34 A New Definition of the Market for Control In light of private equitys increased share of the global M&A marketand of its positive effects on control markets and corporate governance generallyI propose the following variation on Jensen and Rubacks definition of the market for corporate control: The market for corporate control is the market in which providers of capital, or their representatives, compete for the right to govern the corporation. Governance rights include the right to establish governance structures and processes, to hire, fire and set the compensation of top managers, to veto or ratify major strategic initiatives, and to serve as internal consultants to managers.35 By providers of capital I mean not only investors and investment firms, but also corporations seeking to invest in or buy the operations of other companies. While this definition does not mention the managerial labor market, it has strong implications for how that market functions. For example, through the exercise of its governance rights (as just defined), a buyer can retain or fire incumbent managers, or change the structure of its executive compensation contracts. When the corporate control market is redefined in this way, the importance of private equity, both for the control market and the governance of public companies, becomes more clear. Think about what happens when a private equity firm and public company bid for the same business. Corporate bidders bring to the table the risk-bearing benefits of diffuse ownership along with the value of any operational or other synergies between the bidder and target. But set against the value of those advantages are the costs of the companies less effective governance and incentives. Even if they adopt some of the governance and incentive characteristics of private equity, corporate bidders cannot perfectly replicate the structure because of their inability (or unwillingness) to concentrate ownership. Private equity firms, on the other hand, bring the benefits of strong governance and incentives while lacking the benefits of efficient risk-bearing and the possibility of synergies. Now, if we assume that all bidders are rational (in the sense of being unwilling to overpay), a public company
33. Between 2001 and 2007, 12% of all global LBO transactions were done outside North America and Western Europe. For an overview of the Global Impact of Private Equity, see the Executive Summary of the World Economic Forum (2008) Report. It provides references to more detailed research done as part of the forum.

suitor will win the contest for control whenever the benefits of public-market risk-bearing and the synergies associated with the specific business combination outweigh the expected value of the stronger governance and incentives associated with private equity. As a general rule, this is likely to be true in riskier industries with significant economies of scale and growth opportunities requiring large, ongoing investment and infusions of equity. Private equity firms are likely to win the contest under the opposite circumstancesthat is, relatively stable cash flows and limited growth opportunities (though buyout firms have placed increased emphasis on growth in recent years) and modest ongoing investment and capital-raising requirements. But having offered this generalization, with public companies adopting stronger governance practices, and private equity firms gaining access to increasingly large pools of capital and acquiring management and operating expertise in particular industries, the distinctions between the two types of bidders have begun to blur. This convergence of public and private equity practices has at least three important implications: First, private equity will increasingly be viewed as mainstream, as opposed to an alternative, source of capital. Second, the returns to private equity are likely to become more pedestrian, with lower expectations on the part of investors and lower actual returns. Third, stronger governance in public companies implies that we will see fewer cases of the excessive bidding and overpayment by public acquirersas in the case of Time Warners purchase of AOL and the Daimler-Chrysler mergerthat resulted in massive shareholder losses during the late 1990s and early 2000s. The Import of PIPEs and Other Private Placements One of the most visible and striking forms of the convergence of private and public equity markets is the recent growth of private placements of equity, and of a more liquid kind of private placement known as a PIPE (short for private investment in public equity). A private placement is the sale of a block of newly issued stock in a publicly traded company to a single or small group of sophisticated (or at least qualified) investors. The shares are often unregistered at the time of issuance; and unless the issuer files a registration statement, they cannot be traded until held for two years. PIPEs, by contrast, are registered with the SEC within 30 days of issuance and can be publicly traded as soon as the registration becomes effective. Between 1995 and 2007, the number of private placements of equity increased from 127 to 2,430, with aggregate proceeds soaring from less than $2 billion to almost $145 billion. And of the $145 billion raised in 2007, $50 billion, or over a third, took the form of PIPEs.36
34. Sources: Thompson Financial and Dealogic. 35. What I call governance rights include the top-level control rights that Fama and Jensen (1983a and b) and Fuller and Jensen (2002) identify as rights that must be allocated to the board of the directors for governance to be effective.

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A simple or traditional PIPE involves the issuance of common stock at a fixed price, or convertible preferred stock at a fixed price with a fixed conversion ratio. More complex or structured PIPEs involve contingent (or option-like) pricing arrangements, variable conversion ratios, and a variety of other contractual provisions. One recent study of PIPEs reported that they tend to be issued by poorly performing companies, and that contingent pricing provisions tend to be used in cases of extreme uncertainty to allow investors to earn appropriate risk-adjusted returns.37 Consistent with and adding to this picture, another study found that among PIPE investors, hedge funds tend to be attracted to weaker issuers and to protect their returns by using contingent contracting terms.38 But this leaves a number of important questions unanswered. For example, are PIPEs and private placements generally best characterized as partial buyouts, but without the access to governance and reorganization rights provided by a typical private equity purchase of an entire firm? Do private placement and PIPE investors become actively involved in the affairs of the issuer? If so, what role do they play and what is the effect of these relationships on performance? In a recent study, 39 Yilin Wu and I put together a sample of 1,976 private placements of common stock spanning the ten-year period from 1989 to 1999 (ending just before the burst of the NASDAQ bubble, when the number of such transactions fell off sharply) and then hand-collected data on placement terms and investor identity. Although our primary source of data was the private placement contracts, we also used other sources to help identify relationships between issuers and investors, and to classify such relationships as either pre-existing or new. Our study showed, first of all, that almost two-thirds (64%) of the issuers in our sample placed at least some shares with investors with whom they had a pre-placement relationshipthat is, with current managers, key business partners, current 5% or greater blockholders, or current directors. In addition, in many private placements, new relationships, mainly in the form of new directorships, were created as part of the placement agreement. Taking both pre-existing and new relationships into account, we found that only 8% of placements were issued entirely to complete outsiders with no current or previous ties to the firm. Our study also furnished evidence that relationship investors (as defined above) provide issuers with access to larger amounts of capital and gain greater governance influ36. The source is Sagient Research (http://www.sagientresearch.com). Private placements include private investments in public equity (PIPE), 144-A placements and Regulation S transactions. 37. Chaplinsky and Haushalter (2007). 38. Brophy, Ouimet and Sialm (2007). 39. Wruck and Wu (2008). 40. One finding that came as a bit of a surprise was the poor performance of companies making private placements to key business partners where no new relationships were formed as part of the placement agreement. This is confirmed by the estimated

ence than outside investors. But our most powerful and persistent finding was a strong, positive association between new relationships formed as part of the placement agreement and the issuers stock returns and operating profitability over the following two-to-three years. And given that the vast majority of new relationships are governance-related, involving board seats and/or new 5% or greater blocks, this finding constitutes persuasive evidence that the increased monitoring and better governance facilitated by some private placements can create significant value for all investors, passive as well as active. To test the extent to which non-participating public investors benefit from the relationships between private placement investors and issuing firms, we also estimated the alphas (or excess returns) from a variety of simulated trading strategies that were all based on the use of only publicly available information. Depending on the type of relationship involved in the private placement, the issuers stock was either purchased or sold short on the day after announcement and held for two (or three) years. For example, one of our trading strategies was to buy the stock of issuers selling stock to investors with whom they already have a relationship and to short the issuers selling stock only to outsiders. After controlling for market movements, the firm size and book-to-market factors, and momentum, this strategy yielded a two-year excess return of almost 17% striking evidence of the value of relationships to non-participating public investors.40 In sum, our findings suggest that PIPEs and private placements provide an opportunity for productive collaboration between private and public equity. But to make it work, investors must have a relationship that provides them with governance rights or some other means of exerting influence on the issuing firm. In such situations, the private placement can create a partnership in which active investors supply governance expertise while public investors continue to furnish most of the equity capital and bear most of the residual risk. (Whats more, the governance benefits of PIPES can be realized without debt financing, an attractive feature in todays environment.) Bumps in the Road While we have clearly passed the peak of the second major wave of U.S. leveraged buyouts, it seems equally clear that private equity has established itself as a permanent and significant feature of capital markets and the market for corporate control. As discussed earlier, private equity has been a major force in reinvigorating the U.S. corporate control market and strengthexcess returns to the trading strategy of shorting the stock of all issuers selling to key business partners in which no new relationships are formed, and going long in the rest. The returns of this strategy ranged from 17.2% to 29.0%. Our explanation of this finding is that key business partners tend to have pre-placement relationships with the firm that involve some kind of firm-specific investment (consider, for example, an OEM that has invested to become a primary supplier to a specific automobile company). Such investors often find themselves hostage to the fortunes of the issuer, forced to share the pain by virtue of their relationships.

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ening the governance of U.S. public companies. In addition, the principles of reorganization that govern the practice of the top buyout firms have also clearly influenced management practices in a broad range of companies, public as well as private. But there are nevertheless a number of important and controversial issues that have raised bumps in the road. Tax Angles. One policy area of particular concern is the tax code. While some have objected that buyout firms benefit from the tax deductibility of interest, this benefit accrues to all companies, public as well as private, that use debt financingand thus interest deductibility is unlikely to be a target of policy change. But the same cannot be said about the preferential tax treatment of partnership profits. More specifically, earnings received in the form of carried interest are taxed at the capital gains rate rather than at the higher ordinary income rate. And a number of scholars, politicians, and others view this as a loophole that is being aggressively and unfairly exploited by private equity partners.41 The threat of a change to the tax code that more than doubles the effective tax rate on partnership carried interest is very real. With the subprime crisis, the weak economy, and an upcoming presidential election, it has received less attention recently, but will likely come up again. Entry, Exit, and Shifting Markets. Because high profits attract entry, new private equity firms enter the industry during boom times. Other than the ability to raise funds for investment, which is relatively easy during booms, there are few real barriers to entry in private equity. Indeed in 2006, a record 2,700 private equity firms raised over $220 billion for investment, and over 170 funds had over $1 billion in assets under management. But, at the end of a boom cycle, such ease of entry creates potential problems. One problem is that, following a period of rampant entry, many private equity firms lack the experience and expertise in governing and reorganizing portfolio firms required to manage their investments effectively through boom and bust. To the extent active engagement in governance and organizational redesign are fundamental parts of private equitys value proposition, passive approaches to private equity are unlikely to yield adequate returns for the risk borne. When the market contracts, investors in the funds of many of the private equity firms that were able to make money in easier times will experience poor returns. And as a result, the firms themselves will become marginal players, unable to raise new funds. A substantial number of such failures could tarnish the reputation of the industry.
41. For example, Fleischer (2008), a legal scholar, states: Partnership profit interests are treated more favorably than other economically similar methods of compensation, such as partnership capital interests, restricted stock, or at-the-money non-qualified stock options (the corporate equivalent of a partnership profit interest). The tax treatment of carry is roughly equivalent to that of Incentive Stock Options or ISOs. Congress has limited ISO treatment to relatively modest amounts; the tax subsidy for partnership profits interests is not similarly limited. A partnership profit interest is, under current law, the single most tax-efficient form of compensation available without limitation to highly-paid

Moreover, deals-in-progress that are caught in shifting market conditions will either fall apart or require renegotiating. As mentioned earlier, an unusually high percentage of buyout agreements have been terminated in 2008, with a number of such deals being re-struck at lower prices and/or with tighter credit terms. The fallout from such terminations may be increased reluctance on the part of target managers to enter into friendly deals with private equity, which could reduce the opportunity set of viable private equity transactions. Incentive Dilution. A potential agency problem that has received little emphasis to date results from conflicts of interest between general partners (GPs) and limited partners (LPs). It is critical that their incentives are aligned if the private equity market is to function effectively. Under the typical 2 and 20 payout structure, GPs receive a fee of 2% of assets under management annually and 20% of the profit (the carried interest) from the fund. GPs often invest in the fund alongside LPs, typically contributing 1% to 5% of the total. The carried interest, along with the GPs investment in the fund, work to align the incentives of GPs and LPs. But because management fees are paid regardless of performance, they do nothing to align incentives. In addition to management fees, GPs often receive upfront deal fees and monitoring fees, which are also independent of performance. As deals get larger, the management fee, which is effectively a percentage of deal size, becomes substantial. And when the bulk of the rewards from a deal come from noncontingent payouts rather than those based on profitability or share value, GPs have an incentive to close the deal even when the expected returns are inadequate from a risk-return standpoint. This is a clear prescription for too many deals or, more precisely, deals transacted at prices that are likely to turn out to be too high.42 There are also potential incentive problems when private equity firms tap public equity markets. Raising funds through a limited partnership structure imposes a time constraint (the limited life of the partnership) and discipline with respect to how the money can be deployed. In contrast, money raised in public equity markets is permanent capital and imposes far fewer constraints on the issuing firm. Thus, when a private equity firm goes public, the strength of the alignment between partner and investor interests is diminished. The Politics of Finance. The private equity industry would be well-served by considering the potential damage that can be imposed on a sector by what financial econoexecutives. Fleischer (2008), page 2. 42. In my case study of Revcos failed buyout in the late 80s (see Wruck (1991)), I found that, with the exception of one outside investor, all the parties to the transaction received more in fees than they invested in equity, meaning that, even if the equity turned out to be worthless, they still made money. And there is some new evidence that suggests that this could be a problem. Metrick and Yasuda (2007) finds that 60% of the typical partner compensation in their sample of private equity firms comes from fees, with the remainder coming from carried interest.

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mists now refer to as the politics of finance. 43 Unusually high profitability attracts not only attention in the press, but also scrutiny by politicians and regulators. The attack on windfall profits when oil prices rise dramatically is one good example. Another is the press and regulatory attack on the high yield market in the early 1990s. In short, there is abundant historical precedent for political and regulatory responses to situations perceived to be unfair and profits and earnings that are viewed as excessive. But, as those who have been on the receiving end of such responses are aware, there is no requirement that the political or regulatory responses be based on scientific evidencethat is, on the central tendencies, or representative cases, that research helps us to identify. Instead, they are likely to be a reaction to a relatively small number of sensational and highly politicized examples. For example, many legal and finance scholars view at least parts of Sarbanes Oxley as an overreaching and costly regulatory response to a very small number of highly visible and egregious breakdowns in governance.44 The highly publicized payouts that followed Blackstones IPO, and similarly detailed reports of payouts to other private equity players, have the potential to damage the entire sector. Given the negative fallout that can result from this type of media attention, it probably makes sense to award substantial payouts with as little publicity as possible. From Avant Garde to Mainstream? Private equity has evolved from an avant garde, boutique business to an important force in capital markets and in the economy. But if private equity is to be fully accepted, Main Street must be given a better understanding of its role in

facilitating economic growth and creating or sustaining jobs. This will not happen unless the industry communicates its message. People know that General Motors and General Electric are large and important companies. They do not know that the same is true of Blackstone, KKR, TPG, and others. In 2006, taken as a whole, Blackstones 35 to 40 portfolio companies generated over $50 billion in revenues and employed over 300,000 people, making it the equivalent of a top 20 company in the Fortune 500. TPGs portfolio companies generated $41 billion in revenues and employed 255,000. And Carlyles portfolio companies generated $31 billion in revenues and employed 150,000. People know that their welfare in retirement depends on the performance of the stock market, but most do not understand that it also depends on the performance of private equity investmentsand that this dependence is likely to grow. Leaders in the private equity arena are more like successful entrepreneurs than successful investment banker or tradersmore like Bill Gates, the founder of software giant Microsoft, than like Bill Gross, founder of asset management titan Pacific Investment Management. They are the owners and leaders of major businesses, with all the attendant challenges and responsibilities. Addressing these challenges publicly and proactively could make a big difference for both the industry and the economy. karen hopper wruck is Deans Distinguished Professor, Finance
Department at Ohio State Universitys Fisher College of Business

43. Jensen (1991) coined this phrase in describing the fall of the junk bond market in the late 1990s. 44. See, for example, Romano (2004).

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References Axelson, Ulf, Jenkinson, Tim, Weisbach, Michael S. and Strmberg, Per Johan, 2007, Leverage and Pricing in Buyouts: An Empirical Analysis, Working Paper, Swedish Institute for Financial Research. Available at SSRN: http:// ssrn.com/abstract=1027127. Baker, George P., and Karen H. Wruck, 1989, Organizational Changes and Value Creation in Leveraged Buyouts: The Case of O.M. Scott & Sons Company, Journal of Financial Economics, Vol. 25, pp.163-190. Barry, Brian K., Willy Burkhardt and Michael C Jensen, 2001a, Wisconsin Central Ltd. Railroad and Berkshire Partners (A): Leveraged Buyouts and Financial Distress, HBS Case No: 9-190-062 and teaching note 5-899-050. Barry, Brian K., Willy Burkhardt and Michael C Jensen, 2001b, Wisconsin Central Ltd. Railroad and Berkshire Partners (B): LBO Associations and Corporate Governance, HBS Case No: 9-190-070 and teaching note 5-899-050. Berle, Adolf A. and Gardiner C. Means, 1932, The Modern Corporation and Private Property, New York, Macmillan Publishing Co. Bhide, Amar, 1989, The Causes and Consequences of Hostile Takeovers, Journal of Applied Corporate Finance, Vol. 2, pp. 36-59. Brophy, David J., Paige Parker Ouimet and Clemens Sialm, 2008, Hedge Funds as Investors of Last Resort? forthcoming, Review of Financial Studies. Available at SSRN: http://ssrn.com/abstract=782791. Cao, Jerry X. and Josh Lerner, 2007, The Performance of Reverse Leveraged Buyouts, forthcoming in Journal of Financial Economics. Available at SSRN: http://ssrn.com/ abstract=938952. Chaplinsky, Susan J. and David Haushalter, 2007, Financing Under Extreme Uncertainty: Contract Terms and Returns to Private Investments in Public Equity, working paper University of Virginia. Available at SSRN: http://ssrn. com/abstract=907676. DeAngelo, Harry and Linda DeAngelo, 1989, Proxy Contests and the Governance of Publicly Held Corporations, Journal of Financial Economics, Vol. 23, pp. 29-59. Dodd, Peter and Jerold B. Warner, 1983, On Corporate Governance: A Study of Proxy Contests, Journal of Financial Economics, Vol. 11, pp. 401-438. Donaldson, Gordon, 1990, Voluntary Restructuring: The Case of General Mills Journal of Financial Economics Vol. 27, pp. 117-141. Fama, Eugene F. and Michael C. Jensen, 1983a, Separation of Ownership and Control, Michael C. Jensen, Foundations of Organizational Strategy, Harvard University Press, 1998, and Journal of Law and Economics, Vol. 26, pp. 301-325. Available at SSRN: http://ssrn.com/ abstract=94034.
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